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Monday, April 7, 2008

Why Do Equities Give the Highest Returns?

Why does the stock market give higher returns, on average, than bonds or interest on cash? We can observe that this has been true in the past, but why is it true? There are many ways to answer this question, but I’ll pick just one.

Everything else being equal, people tend to prefer lower risk investments. Most people would take a sure 5% return over an investment that has a 50/50 chance of giving either 0% or 10%. It’s just sensible to reduce risk if you can do it without giving up anything else.

All investments have some type of risk. With an individual stock, the main risk is that the company will produce lower than expected profits. Stocks are riskier than bonds and interest on cash. So, stocks have to offer higher returns than bonds and cash to attract investors.

Suppose that most people believe that the stock market will give lower returns than bonds for the next decade. This would cause people to sell stocks and buy bonds leading to stock prices dropping and bond prices rising. Eventually, with the price changes, we would get to the point where people believed that stocks and bonds would give the same returns for the next decade.

But, it wouldn’t stop there. People would still prefer bonds because bonds would offer the same expected returns with lower risk. Investors would keep selling stocks and buying bonds. Once prices stabilized, stock prices would be low enough that stocks would offer higher expected returns than bonds.

Assuming that everyone was right in their expectations, stocks would then give higher returns than bonds in the future.

What if everyone is wrong?

The prices of stocks and bonds reflect the opinion of the masses. But, what if everyone is wrong? Doesn’t that mean that stocks could give lower returns than bonds? Yes, this could happen. However, it is much more likely to happen when everyone is optimistic about stocks than when they are pessimistic. Optimism drives up prices and lowers future returns.

In fact, investors like Warren Buffett with cash to invest prefer to see widespread pessimism about stocks to bring down stock prices. When most people are optimistic about future stock market returns, they bid up prices. When prices are high, Warren Buffett knows that future returns are likely to be much lower than everyone else believes, and he can’t find anything to buy at a good price.

Can everyone be wrong indefinitely?

If most people are overly optimistic, prices will rise to the point where strong future returns aren’t possible. This situation can’t last forever. Eventually, returns will drop and the masses will stop being so optimistic. However, prices can be out of line either too high or too low for extended periods.

It is conceivable, but not likely, that stock returns could be unreasonably low for 20 years. The only scenario I can see where stock returns can remain lower than bond returns for much longer than this is if the economy is in a permanent death spiral.

So, if you believe that China will crush the US and eventually destroy the US economy, then by all means, get out of stocks and stay out. I’m going to take a chance that the Canadian and US economies will continue to thrive with various ups and downs, but no death spiral. I’ll stay invested in stocks.